In a speech to Scottish business organisations, Mervyn King, the Governor of the Bank of England, argued that it might be necessary to split banks up. The aim would be to separate the core retail banking business, of receving deposits and lending to individuals and businesses, from the more risky and exotic wholesale acitivites of banks, such as securitisation, speculation and hedging – so-called ‘casino banking’.
Governments around the world, as represented at the G20 meeting at Pittsburg in September, have favoured tougher regulation of banks. But Mervyn King believes that this is not enough. It may not prevent the reckless behaviour that resulted in the credit crunch and bank bailouts by the government. “Never has so much money been owed by so few to so many. And, one might add, so far with little real reform.” And if regulation were to fail and banks were to get into difficulties, what would happen? There would have to be another bailout. As Mervyn King said, “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”
There are two key problems.
The first is Goodhart’s Law. If rules are set for bank behaviour, banks may adhere to the letter of the rules, but find ways around them to continue behaving in risky ways. The rules may cease to be a good measure of prudent behaviour.
The second is moral hazard. If banks know that they will be bailed out if they get into difficulties because they are too big to fail, then this encourages them to take the risks. As Mervyn King said in his speech, “The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The ‘too important to fail’ problem is too important to ignore.”
So should the banks be split? Is there any likelihood that they will? Or are Mervyn King’s proposals merely another headache for the government? The following articles looks at the issues. The first link below is to his speech.
Speech by Mervyn King, Governor to Scottish business organisations, Edinburgh (20/10/09)
Mervyn King: bail-outs created ‘biggest moral hazard in history’ (including video of part of speech) Telegraph (20/10/09)
Governor warns bank split needed BBC News (20/10/09)
A sombre warning BBC News, Stephanomics (20/10/09)
Alistair Darling rebuffs Mervyn King’s attack over timidity of banking reforms Guardian (21/10/09)
King and Brown in rift over whether to split the banks Independent (22/10/09)
Tucker set to join calls for stricter controls on banks Scotsman (22/10/09)
Testing times for bank regulators Financial Times (21/10/09)
Mervyn King is right – the economy is changing and we’re blindfolded, without a map Telegraph, Edmund Conway (22/10/09)
Questions
- Explain what is meant by ‘moral hazard’ in the context of bank bailouts. Are the any ways in which banks could be prevented from failing during a crisis without creating a moral hazard?
- Does regulation necessarily involve Goodhart’s Law? To what extent is it possible to devise regulation and avoid Goodnart’s Law?
- What are the arguments for and against splitting banks’ core business from more risky ‘casino banking’?
- Does the separation of retail and investment banking necessarily involve splitting banks into separate organisations? If they are not split, how can the government or central bank underwrite retail banking without underwriting riskier investment banking?
CPI inflation in the 12 months to September 2009 fell to 1.1% (from 1.6% in the 12 months to August). RPI inflation for the same period was -1.3%. In other words, retail prices actually fell by 1.3% in the 12 months to September. According to the ONS, “By far the largest downward pressure affecting the change in the CPI annual rate came from housing and household services. This was principally due to average gas and electricity bills, which were unchanged between August and September this year but rose a year ago when some of the major suppliers increased their tariffs.” (See below for link.)
If the CPI inflation rate falls below 1% (or rises above 3%), the Governor of the Bank of England is required to write a letter to the Chancellor of the Exchequer explaining why and also what the Bank of England intends to do about this. The Bank of England targets the forecast CPI inflation 24 months’ hence and attempts to achieve a rate of 2%. Normally, if the forecast rate is below 2%, the Monetary Policy Committee will decide to cut the rate of interest. The last Bank of England Inflation Report (August 2009) forecast CPI inflation of around 1.5% in 24 months’ time. If the November Inflation Report forecasts a similar figure, or even below, what can be done? Bank Rate is already at a historic low of just 0.5% and a further cut is unlikely to have much effect. Should the Bank of England, then, engage in another dose of quantitative easing? Perhaps the letter, if it has soon to be written, will make it clear.
UK consumer price inflation at 5-year low BusinessWeek (13/10/09)
Recession helps push inflation to five-year low Independent (14/10/09)
Inflation falls to lowest in five years Guardian (13/10/09)
Inflation dip likely to be short-lived Guardian (13/10/09)
Deflation, not inflation would be the bigger threat if the Conservatives do what they say Jeremy Warner blog, Telegraph (13/10/09)
Pound hit by falling UK inflation BBC News (13/10/09)
Pound hit by falling UK inflation (video) BBC News (13/10/09)
Pound pays price as inflation slides to five-year low Times Online (14/10/09)
Investors weigh risks of inflation and deflation Financial Times (12/10/09)
Wage ‘catch up’ for public sector BBC Today Programme (14/10/09)
Current data on UK Inflation (National Statistics)
Time series data (annual, quarterly and monthly) on UK prices and inflation Economic and labour Market Review (National Statistics)
Questions
- Why did the annual rate of CPI inflation fall so much in September 2009?
- Is the Bank of England Governor likely to have to write a letter (or letters) to the Chancellor in the coming months? Explain why or why not. What is likely to be the role of expectations in determining whether a letter has to be written?
- Why did the sterling exchange rate fall on the announcement of the inflation figure? What are likely to be the effects of this? What will determine the size of these effects?
- Why may additional amounts of quantitative easing be necessary in the coming months? How would a contractionary fiscal policy affect the desirability of additional quantitative easing?
In 2008, as the economy was on the verge of recession, the UK Prime Minister said that we would ‘spend our way out of it’ despite rising levels of public-sector debt. In recent weeks, however, the focus has been much more on tackling the debt, which has now increased to over £800 billion (58% of GDP) – it was £500 billion at the end of 2006 (37% of GDP).
Although the current level of general government debt in the UK as a proportion of GDP is still one of the lowest of the G8 countries, it is rising the fastest. In other words, the general government deficit as a proportion of GDP is the highest (see Table A8 in IMF World Economic Outlook, Statistical Appendix A). The IMF’s forecasts suggest that, by 2014, government debt could be as much as 92% of GDP – the highest since World War II – and lower only than Japan (144%) and Italy (126%) of the G8 countries (although the USA, Germany and France are forecast by then each to have government debt over 80% of GDP).
Gordon Brown has said that public spending will have to be cut back once the recession is over, mainly by cutting out waste in the public sector. Conservatives too are looking to make substantial cuts in public expenditure if they come to office next year and have talked of an era of austerity.
But will such cuts be too little too late? Has government spending on saving the banks and trying to boost the economy by cutting VAT actually damaged our recovery prospects and are the British people going to be the ones to suffer? Or should the fiscal stimulus be retained for some time yet to prevent a lurch back into recession? The following articles look at the public debt situation, which poses some interesting policy questions, especially with the Party Conferences!
£805,000,000,000: UK’s monstrous debt The Mirror (19/9/09)
Osborne gambles with cut plans BBC News (6/10/09)
Governments will have legal obligation to reduce UK’s debt Telegraph (28/9/09)
We’ll spend our way out of recession Independent (20/10/08)
Public sector borrowing soaring BBC News (18/9/09)
Govt spending cuts ‘could help pound’ Just the Flight (21/9/09)
Deficit danger worries Cameron BBC News (4/10/09)
Public debt hits £800 billion – the highest on record Times Online (19/9/09)
Pay freeze ‘to protect UK services’ The Mirror (6/10/09)
This recession demands that we employ logic and spend our way out of it Telegraph (11/1/09)
Cuts and pay freezes ‘just the beginning’, Tories admit Telegraph (7/10/09)
Robert Stheeman: So what’s worrying the banker in charge of our £1trn debt? Independent (8/10/09)
Has Darling or Osborne the best plan for cutting the deficit? Observer (11/10/09)
This public-spending squeeze will be much tighter than people expect Independent on Sunday (11/10/09)
Tax and spending squeeze will keep Bank rate low Sunday Times (11/10/09)
UK rates ‘to stay low for years’ BBC News (11/10/09)
Questions
- According to economic theory, how does increasing government spending or reducing taxation aim to boost the economy?
- What do we mean by a budget deficit or budget surplus? How does a budget deficit differ from national debt?
- What is the ‘golden rule’ for fiscal policy? Discuss the advantages and disadvantages of such a rule-based approach to fiscal policy.
- What are the advantages and disadvantages of a policy of ‘spending our way out of a recession?’
- With spending cuts looming, many will be affected. How will cuts in government spending affect the UK’s ability to recover from the recession? Will you be affected and, if so, how?
- Last year £85.5 billion was spent by the government on bailing out banks. Do you think this was money well spent, or is it the main cause of the current spending cuts that could see the recession worsen?
The housing market has been very volatile over the past year or so. House prices crashed, but then appeared to stabilise. Since then, however, different sources have given very different opinions and predictions about future movements. According to Nationwide Building Society, house prices have increased by an average of £53 a day during September, but others suggest that they remain stable and that they may fall again in 2010.
Not only are house prices important to those buying and selling, but the state of the housing market is also crucial for the recovery of the economy. For example, the construction industry has suffered over the past year and, as of the 2nd October 2009, unemployment in this sector stood at 17.1%. As more and more workers lose their jobs, their disposable income falls and hence demand in the economy is affected. With the possibility of an election debate between the party leaders, many will be waiting to see what their strategies are to revitalise a struggling economy.
House prices rise an average of £53 a day’ Daily Record, Clinton Manning (3/10/09)
Mortgage approvals dip in August BBC News (29/9/09)
Construction contracts at slowest pace for seven months Construction News, Nick Whitten (5/5/09)
House sales ‘stalled’ in August BBC News (22/9/09)
Housing market needs ‘feel-good’ factor to recover City Wire, Nicholas Paler (26/6/09)
Double whammy for first-timers as prices stabilise and loans dry up Scotsman, Jeff Salway (3/10/09)
Head-to-head view on house prices BBC News, Kevin Peachey (27/8/09)
UK construction industry still contracting, says Cips Guardian, Kathryn Hopkins (2/10/09)
House prices see ‘slight decline’ BBC News (28/9/09)
House prices ‘back to 2008 level’ BBC News (2/10/09)
Construction unemployment rises to 17.1% HomeTown Sources (2/10/09)
House prices up – but so are insolvencies Management Today (2/10/09)
Financial shadow cast by city apartments BBC News (8/10/09)
For house price data see:
Nationwide House Prices
Halifax House Price Index from the Lloyds Banking Group
Housing Market and House Prices from the Department of Communites and Local Government
Questions
- Why are recent movements in the housing market going to be a problem for first-time buyers?
- The ‘Stamp duty holiday’ will soon come to an end. What do you think will be the impact on the demand for and supply of houses and hence equilibrium prices over the next 6 months?
- One of the reasons why house prices have stabilised is a lack of supply. How does this affect equilibrium prices?
- Why is the economy so affected by changes in house prices? Think about what happens when construction workers lose their jobs and how this affects aggregate demand. Then consider how the macroeconomy will be affected.
- When demand for houses increases, why do prices increase so rapidly? Consider elasticity.
The following two clips look at John Maynard Keynes’s contribution to macroeconomics and whether his theories have been proved to be correct by the events of the past two years.
“What would John Maynard Keynes make of the financial crisis and the credit crunch?” In the first clip, “Author Peter Clarke, former professor of modern British history at Cambridge University, and the former Conservative chancellor Lord Lamont consider whether Keynes’s ideas were twisted by modern politicians to support their desires to run big spending deficits.”
What would Keynes make of the crisis? BBC Today Programme (25/9/09)
Is Keynes influencing today’s politics? (video) BBC News (2/10/09)
Questions
- How is the recent crisis and recession similar to and different from the Great Depression of the inter-war period?
- Can recent fiscal policies adopted around the world be described as Keynesian?
- How would a government of a Keynesian persuasion attempt to manage the move from recession to economic growth and deal with the problem of mounting public-sector debt?